Thank You

Error.

Not that anyone arriving in one of its stylish lobbies would know, but for the past decade,
Starwood Hotels & Resorts Worldwide
has been remaking itself into a manager of hotels rather than an owner of hotels.

Since 2000, Starwood (ticker: HOT) has sold 110 properties for $7.5 billion, including the seminal sale six years ago of 33 luxury properties to Host Marriott for $4.1 billion. Result: Starwood now gets 57% of its operating earnings from managing hotels that are owned by others but operate under its brands, including Sheraton, Westin and W.

Eleven years ago, that figure was just 16%.

Thanks to this "asset-light" strategy, Starwood is well on the way to its goal of getting 80% of operating earnings from fees. It finished the second quarter with 998 managed or franchised active hotels, and 350 in the pipeline. By contrast, Starwood owns outright only 60 hotels.

For the White Plains, N.Y., company, the move to "own" guests rather than hotels has been a big winner, resulting in higher growth, higher margins, higher return on capital and higher cash. Cash flow is estimated to come in as high as $1 billion this year, up from $879 million in 2010, helping to keep the balance sheet healthy. Management has been using cash to keep paying down debt.

YET, AMID RISING global economic uncertainties, particularly in the important European market, and fears of a looming recession, Starwood shares, along with those of other hotel stocks, have been hit hard. At a recent 41.49, the stock is off 32% this year through last Thursday, with more than half that drop occurring since the end of July.

Investors fret about the company's ability to sell more properties in this environment, especially as traditional buyers of these kinds of assets, the lodging-related real-estate investment trusts, have also seen their strongest currency for transactions—their stocks—decline in price. There is worry, too, that the recovery in corporate and leisure travel will be cut short as businesses and consumers clamp down on spending.

The selloff in Starwood shares could well be overdone. Some savvy investors now see an opportunity to buy a premier hotel-management and franchising company, one with an important niche in the luxury and boutique market and a fast-growing international presence, especially in China, at a compelling discount to its growth prospects.

"Starwood is an international hotel-management company with robust growth that is being valued as if the world will stop traveling," says Quoc Tran, portfolio manager at Lateef Investment Management in Greenbrae, Calif., who took a position in the company this summer.

Tran values the shares at 81, based on a sum-of-the-parts analysis of Starwood's rooms, management fees and time-share business. That's almost double where they now trade, and would lift the company market value to more than $15 billion.

"Their loyalty program is well-known and top-ranked; their reservation and marketing network is one of the strongest in the world; its brands are recognized by world travelers; and flying the Starwood flag is economically advantageous," says Amit Kapoor, a lodging analyst at Gabelli & Co. who recommends buying the shares. "Starwood will be the greatest beneficiary of any uptick we see in travel, be it corporate or leisure."

The Bottom Line

Starwood shares, beaten down by fears about the global economy, now look like a bargain. Some bulls think the stock is worth about $80, up from around $41 recently.

Kapoor thinks the shares are trading well below their value, which he reckons is 75 a share, based on a multiple of 14 times 2012 cash flow. If there's a slowdown in travel and a resulting contraction in the multiple to, say, 12 times cash flow, Starwood's value would fall only to 65 a share, still nearly 60% higher than now.

Based on the sale prices so far this year for 17 full-service hotels, which have fetched $425,000 per room on average, the 60 hotels now owned by Starwood would be valued at about $8.2 billion, more than the entire current market value of the company. In addition, there are $600 million in management, franchise and vacation-ownership fees.

While acknowledging the unsettled geopolitical environment and uncertain macroeconomic conditions, Starwood management in July reiterated its full-year outlook for cash flow of between $975 million and $1 billion in 2011, with company officials noting that they were more comfortable with the midrange of that outlook. In addition, management forecast a 7% to 9% increase in revenue per available room for hotels it operates world-wide and open for at least a year.

PRIORITIES FOR THE CASH, the company said, would be paying down debt maturing in 2012, in an effort to achieve a triple-B investment rating, and reinvesting in its business to drive future growth. It intends to take a more conservative approach with its cash management than it might have in the past, given the fragile economy and the lessons of 2008-09.

Starwood also put full-year earnings, before special items, at between $1.67 a share and $1.77 a share, up 34% to 42% from 2010. The outlook doesn't include revenue and cash flow from expected fourth-quarter sales of timeshare residences at the company's new St. Regis Bal Harbour Resort in Florida, where interest from Latin American buyers proved strong. Prices on Starwood's time-share residences increased in the second quarter for the first time in four years.

The robust growth has been achieved this year—despite the loss of an estimated $25 million to $30 million in cash flow from properties in Africa and the Middle East that are underperforming due to political unrest in those regions, and to a slow recovery in Japan from the earthquake and tsunami in March.

Going Places

Starwood expects its full-year earnings for 2011 to rise 34% to 42% from 2010, before special items.

Management declined to comment for this article, citing the quiet period ahead of reporting third-quarter results on Oct. 27. In July, it forecast earnings to come in at 36 cents to 40 cents a share, before special items, versus 25 cents a share in the year-earlier period, for a 44% to 60% gain.

Even if asset sales slow, Starwood should continue to benefit from extensive operating leverage. The company figures that increases in room rates will be the main driver of its results this year, because there's been little growth in supply in the U.S. and Europe since the credit crisis of 2008, and the supply is expected to be tight for the foreseeable future. That's driven occupancy rates higher and led to strengthening room rates. Rates on group business—meetings and conventions—beyond 2012 are up by close to 13%, and there has been a strong pickup in business booked more than 12 months out.

A LOT OF THE EXCITEMENT surrounding Starwood is based on its growing presence in emerging markets, and the potential in China and India. Reflecting its commitment to China, Starwood's senior management team relocated to Shanghai from White Plains for the month of June, to deepen its understanding of the market as well as its relationships with developers. Another plus: The move generated lots of positive publicity.

Starwood operates 75 hotels in China, and has almost another 100 under construction, to take advantage of the fact that travel in China is growing at a rate of 15% to 20% a year. Right now, there is only a fraction of the number of high-end hotels needed to support that growth. Even after that kind of buildout, Starwood estimates that the total number of its hotels in China will be only one-third the size of its U.S. footprint, though the country has a population of 1.3 billion, versus 310 million in the U.S.

Of the major U.S.-based hotel companies, Starwood boasts the biggest number of hotels in China, having opened 15 upscale and luxury properties in 2010, more than double that of Marriott and five times that of Hilton, according to Smith Travel Research.

Starwood's Sheraton brand accounts for half the portfolio in China, and its Westin and Four Points by Sheraton brands comprise another quarter. The company is catering to China's lust for luxury brands—the country is the world's biggest market for high-end names—by rolling out nine St. Regis hotels, positioning China to become the biggest market for that brand. It is also adding to its luxury collection of individual high-end properties in China.

Wherever it goes, Starwood is winning the hearts of more and more travelers. More than half of the room stays at its hotels come from the 13 million members of the Starwood Preferred Guest rewards program, and the company expects that to rise to 60% in the next few years.